date: 20 jul 2006 mrs smita shukla - wordpress.com replaced the foreign exchange regulation act of...

Mgmt study material created/ compiled by - Commander RK Singh [email protected]

of 58 - International Finance (Ver 1.3)

Jamnalal Bajaj Institute of Mgmt Studies

Date: 20 Jul 2006

Mrs Smita Shukla

Recommended Books –

1. International Finance – PG Apte (Best book but for higher level. Students who have finance

background may opt for this. Can be referred by novices like me for Forex Arithmetic)

2. Multinational Finance – Madhu Viz (Most Recommended for all. But not the best book for

Forex Arithmetic)

3. International Finance – Jain & Others (A balanced book for theory and numericals). 4. International Finance – Levi

5. Global Finance Markets – Giddy

6. Foreign Exchange and Derivative – Jain and Others

7. International Finance – Bhalla.

Students should build their knowledge by regularly going through business journals,

magazines and newspapers.




What is Foreign Exchange?

Foreign Exchange loosely refers to any foreign currency. In deeper sense, it is purchase and

sale of one currency against sale and purchase of another currency. Here, currency does not

necessarily mean bank notes and coins but includes Travellers Cheques, Bills of Exchange,

Letters of Credit, any drafts, etc as well. In essence any financial instrument that entitles

you to get another currency in lieu of one currency is treated as currency for this definition.

International Foreign Currency market is almost round the clock market starting in

Tokyo/Sydney in the morning and closing in West Coast of USA shortly before it is time

for opening of next day market in Tokyo (effect of changing time zones).

Indian Forex Market

Indian Forex Market is still in nascent stage of development. Prior to 1991, we had FERA

which made possession of Foreign currency a criminal offence. Exchange rate was decided

by the RBI and Forex market virtually did not exist. Post 1991, after replacement of FERA

with FEMA, and current account convertibility, Indian forex market has begun to develop.

With exports volume growing steadily at good pace, forex market is becoming important.

The Foreign Exchange Management Act (1999) popularly known as FEMA came into

force from June 01, 2000. FEMA replaced the Foreign Exchange Regulation Act of 1973

(FERA). While FERA was aimed at conserving foreign exchange by restricting

expenditure, FEMA is aimed at facilitating external trade and payments for promoting

orderly development and maintenance of foreign exchange market in India. Violations

under FEMA are considered civil offence and not criminal offence as was the case under

FERA.

In India, most of the trade happens in USD. Besides US Dollar, Euro, Great British Pound,

and Japanese Yen are other major currencies that are traded. Other currencies are also dealt

but in small volume. SBI deals in 16 currencies in all.

Exchange rates are not constant and keep changing on minute to minute basis like stocks in

stock market. Unlike “Stock Exchange”, there is no “Forex Exchange” where there is a

central intermediary available for every transaction and hence single quote for any currency

is not available. It is more like a vegetable market where there are so many shops and each

is quoting its own rate for each vegetable and willing to bargain with you. Or, in the market

language, it is Over the Counter (OTC) trade.

Foreign Currency Exchange Rate

The primary basis for exchange rate movement on day to day basis is Demand and Supply

of foreign currency. Demand can spurt due to various reasons like large companies with

considerable import requirements (like Maruti requiring import from Suzuki, Japan) stocking forex

for future requirement. Similarly, exporters may dump their forex holding if they perceive

that rupee is going to appreciate, leading to sudden excess availability of foreign currency

in the market.




Although the exchange rate is affected by market forces of demand and supply, we do not

have a fully flexible exchange rate, or as it is called Floating Exchange Rate, as yet. What

we actually have is a Managed Exchange Rate.

What it means is that exchange rate is being macro managed by the Govt through RBI. RBI

keeps a hawk eye on the forex market and keeps manipulating exchange rate by either

buying excess forex or injecting liquidity by selling forex from its own holding of 165

Billion US Dollars.

Like, SEBI is the controller of the Securities market, RBI is the controller of Forex market

in India. It authorises certain entities like banks and even other companies like Thomas

Cook to deal in Forex. It has a dealing room of its own which keeps track of exchange rate

movement in the market on continuous basis. If the exchange rate starts moving wildly in

either direction, it intervenes by either buying or selling forex in the market to control it.

Factors Affecting the Exchange Rate

(a) Balance of Payment position of the country

(b) Strength of economy

(c) Fiscal and Monetary policy

(d) Interest rates

(e) Political Factors

(f) Exchange control

(g) Central Bank Intervention

(h) Speculation

(i) Technical Factors

(j) Other factors.

Balance of Payment - Balance of Payment is the measure of demand and supply

of foreign currency. If the balance of payment is positive and high (Exports higher

than imports), it will lead to excess supply of foreign currencies and therefore local

currency will appreciate. In the reverse case, domestic currency will depreciate.

Strength of the Economy - If the economy is strong and growing, foreign

investment/capital will pour into the country, again causing excess supply of

foreign currencies leading to appreciation of local currency.

Fiscal and Monetary Policy - If fiscal policy leads to high deficit, it will result in

inflation and therefore excess supply of local currency. High inflation rate leads to

high interest rates (interest rates are mostly maintained a few percent higher than inflation rate

so that real effective interest rate is positive) leading to weakening of local currency.

Interest Rates - Higher interest rates attract foreign currency deposits provided

local currency is not depreciating faster than interest rate induced growth. Thus,




higher interest rates coupled with relatively stable local currency acts like a self

sustaining process. More inflow of foreign currency leads to further stability of

exchange rates.

Political Factors - If a govt is considered to be unstable, or change of govt with

socialistic inclination is expected, local currency will weaken. Currency will

strengthen if the new govt is expected to take capitalistic policy decisions.

Exchange Control - Exchange control is generally aimed at free movement of

capital flows and therefore foreign nationals will be wary of investing in the

country.

Central Bank Intervention - Already explained as to how central bank can affect

exchange rate in the short term.

Speculation - This is again a short run effect if some big players suddenly start

accumulating foreign currency or vice versa for speculative reasons. Constant

buying by big players and resultant upward movement in price leads even smaller

player to start buying aggressively and foreign currency appreciates.

Technical Factors - Technical factors work best in free market. Indian forex

market is still not as free and therefore they do not have much effect.

Other Factors - These are general factors which are hard to define. It could be

world political and economic situation, prices of major import constituent like crude

oil, etc. Fear of war with Pakistan can send the Rupee down overnight.

Reference Rate

What we have discussed above is mechanics of day to day changes in exchange rate. But

how is the basic exchange rate of one currency set against the other currency? How is it

determined that a dollar should cost approximately Rs 45 and not Rs 25?

Current mean of Rs 45 or so is called Reference Rate. This reference rate is decided using

various different methods: -

(a) Mint Parity System – Simply stated this system is based on amount of

currency printed by any country for each ounce or Kg of gold. If India prints

Rs 30,000 for each ounce of gold held with govt and US prints US$ 600 for

each ounce of gold held with USA, exchange rate between US$ and INR

would be – 30,000/600 = Rs 50 per dollar.

(b) Gold Standard System – This system started in mid 1870s and lasted till

1914 ie till start of World War I. In this system, the coins had a fixed gold

content and ratio of gold content in coins of any two countries denominated

their exchange rate. In case of paper currency, amount of gold freely

payable by Govt/Central Banks of two countries for each unit of paper

currency determined the exchange ratio. The countries were committed not

to print currency in excess of their gold holding or dilute the gold content in

coins. However, during the World War I, countries began to renege on this




commitment to meet the funding requirement of the war and the gold

standard collapsed.

Many countries tried to revive the Gold Standard after the war ended

in 1919 but failed. In the economic depression that followed the WW-I,

when they tried to withdraw additional money they had pumped into the

economy during the war, it led to Deflation (reverse of inflation where commodity

prices start falling due to low demand (because people do not have money to buy goods)

which deters the entrepreneurs and is therefore bad for economy). They, therefore, had

to wait for the economies to recover. But by the time they began their next

attempt a couple of decades later, World War II started in 1939 and lasted

till 1944. Thus, this standard was abandoned.

(c) Bretton Woods System – Post World War II, in 1946, the newly-created

Economic and Social Council of the United Nations called a conference at

the Bretton Woods where in the troika of post-War economic agencies ie

International Monetary Fund (IMF), World Bank and International Trade

Organisation (ITO – which later came in avatar of GATT) were born.

Countries were allowed to declare their currency value in gold or dollars and

USA promised to freely exchange an ounce of gold for US$ 35 or vice

versa. Since this system was born during Bretton Woods conference, this

standard came to be known as Bretton Woods system.

The system worked very well till 1969. However, when USA got

embroiled in the long and costly Vietnam war, its economy suffered. The

U.S. trade balance on goods and services shifted to a surprising deficit in

1971. These deficits supported speculations that the dollar was overvalued.

France realised that it was beneficial to exchange its forex holding into gold

and began to convert it. Because of massive gold outflows from the United

States, President Nixon suspended convertibility of the dollar in August

1971. This ended the Bretton Woods System.

(d) Smithsonian Agreement - IMF’s attempts in the subsequent period to revive

Bretton Woods system were unsuccessful as USA did not agree to make

dollar convertible to gold. In the following period, there was complete

chaos. In an attempt to restore order to the exchange market, 10 leading

nations met at the Smithsonian on December 16 and 17, 1971. The

“Smithsonian Agreement” was a new system of exchange-parity values.

Although this new system was still a dollar-standard exchange-rate system,

the dollar, was still not convertible to gold. Smithsonian Agreement

collapsed within 15 months and a de facto system of floating rates emerged.

(e) Now we have following systems of Exchange Rate being followed by

different countries as per their convenience:

(i) Fixed Exchange Rate Systems




(aa) Currency Board

(ab) Fixed Peg

(ac) Flexible Peg

(ii) Floating Exchange Rate Systems

(aa) Managed Float System

(ab) Independent Float System

Scientific Way of Deciding Exchange Rate Between Currencies

1. Purchasing Power Parity System - This theory is based on the law of one price, the

idea that, in an efficient market, identical goods must have only one price. This is

thus Real Effective Exchange Rate (REER). A basket of representative goods and

services has been identified and its cost in each country in its domestic currency is

calculated. The ratio between its costs in any two countries in their respective

domestic currencies is their exchange rate. To understand it better, let us take a case

of cost of hair cut in India and US. While the average price of a hair cut in India is

Rs 15, it costs US$ 3 in US. If this was to represent average ratio of costs for all the

goods in the basket, purchasing power parity of US$ would be 5 against INR.

The differences between PPP and market exchange rates can be significant.

For example, on plain conversion of Yuan to dollar basis, per capita GDP in China

is about USD 1,500, while on a PPP basis, it is about USD 6,200. Same is the case

of India. Per Capita GDP by PPP in 2000 = USD 2686) At the other extreme,

Japan's nominal per capita GDP is around USD 37,600, but its PPP figure is only

USD 31,400.

Exchange Rate = Price in domestic market for basket of goods = Pd

Price in foreign market for basket of goods Pf

This is called absolute version of PPP.

These special exchange rates are often used to compare the standards of living of

two or more countries. The adjustments are meant to give a better picture than

comparing gross domestic products (GDP) using market exchange rates.

2. Relative Purchasing Power Parity – This is a related theory, which predicts the

relation between the two countries' relative inflation rates and the change in the

exchange rate of their currencies. This is the economist’s definition. In business

terms, it helps in deciding Forward Rate of Forex from Spot Rate by taking inflation

into account.

Suppose, present Exchange Rate of dollar in India is Rs 47 and inflation in

India is 5% and in US 1%. Thus, cost of same product after one year in India =

PD (1+ 0.05) and in US = PF (1+ 0.01).




Thus, exchange rate after one year = PD (1+ 0.05)

PF (1+ 0.01)

= Rs 48.86

But Inflation is not the only element that affects the long term exchange

rates. Interest rate is another element that severely affects the exchange rate (although interest rates are often a direct function of inflation, Interest rates is pegged to covered

the depreciation of money through inflation and a little as incentive. Thus, if inflation is low, interest

rates would automatically be correspondingly low).

3. Interest Parity Theory – Effect of interest on exchange rate is called Interest Parity

theory. Let us see how a smart operator can benefit by playing currency of two

countries having differential interest rates and gain from it.

Suppose, current exchange for US$ is INR 46. RBI bond interest rate is 7%

and US treasury interest rate is 2%. A smart American investor instead of investing

in US treasury bill would invest in RBI bonds. (this is what NRIs do with NRE and other

accounts). However, whole thing is not as simple as it appears. When such arbitrage

opportunity occurs, many people try to utilise the opportunity and resulting excess

supply leads to fall in exchange rate. Further, inflation in India is higher than in US.

Therefore, on maturity of deposit, reverse conversion of Rupee deposit to dollars is

going to be at higher cost than the original conversion rate Thus, losing of some

gains.

Sterilisation of Forex

While every country is bending over backwards to earn as much forex as possible, there is

limit of each economy to absorb forex inflow. Uncontrolled influx of forex can be harmful,

especially the hot money which can be withdrawn at short or nil notice, like portfolio and

stock market investment with capital account convertibility. (This is what was the prime cause of

South Asian Economic crisis of 1997). Also, influx of huge funds leads to inflation. Therefore,

there are times when forex inflows have to be checked or controlled. Technically such a

process is called Sterilisation of Forex. Recently, India adopted this approach by reducing

interest rates on NRE deposits which made parking of funds in India less attractive.

Another way of sterilisation is to liberalise Imports. Surge in imports takes away excess

supply of dollars in the market. Yet another method is to repay the old debts.

The methods we discussed above are the planned and controlled method of

Sterilisation of Forex. In addition, there could be host of uncontrollable and unpredictable

reasons leading to sterilisation, like –

(a) Threat of War

(b) Increase in oil prices

(c) Political Instability

(d) Govt Policies

(e) Social Disturbance




Fixed Exchange Rate Systems

1. Currency Board – Currency Board arrangement is one where a country declares

value of its domestic currency against some other strong currency. In this system,

currency notes issued by the country depend upon the declared exchange rate and

the amount of foreign currency reserves. If India gets into US currency Board and

has a forex reserve of US$ 150 Billion and exchange rate is Rs 40, India can issue

150 x 40 = 6000 Billion Rupees worth of currency notes. Thereafter, Indian

currency will move in tandem (same ratio) with USD. Domestic currency is also

fully convertible into foreign currency and vice versa. However, in this case,

monetary policies have to be in consonance with other country. Thus, it kills the

economic sovereignty of the nation and therefore difficult to follow.

Examples are Argentina, Hong Kong, Estonia, and Bulgaria

2. Fixed Peg – In this system, exchange rate is declared by the country and ratified by

the IMF. Thereafter, exchange rate does not change till it is revised by the Govt.

Reluctance by the govt to revise the rate due to political or other compulsions can

lead to long term consequences. South East Asian crisis was partly result of this

system.

Reasons for South East Asian Crisis (1997)

(a) Countries had adopted complete convertibility on Current as well as Capital

account. This made flight of capital very easy. There was no way to control

outward flight of capital at the time of crisis.

(b) They adopted Fixed Peg system against dollar. There was massive influx of

foreign currency through hot investments, foreign currency loans by banks,

etc. This money was invested in assets like real estate and stocks. There was

massive rise in asset prices and an asset bubble was created.

(c) There was massive current account deficit. Imports far exceeded exports.

(d) High inflation rates due to increased money supply. Inflation was not

reflected in exchange rate; firstly, due to Fixed Peg system and secondly,

due to govts’ reluctance to revise the rate downwards which would have

affected investors’ sentiments. Speculators suddenly realized that due to

overvalued currencies, it was beneficial to convert local currency into

dollars and they went for it hammer and tongs. Due to relatively small size

of economies (a few tens of billion dollars each), and therefore small forex

reserves, in three trading sessions, Forex reserves became nil.

3. Flexible Peg System – This system provides a “Parity band” which allows limited

flexibility for movement of exchange rate on either side of the parity rate. Bands

can be very narrow or very wide. Examples are Bangladesh, China, and Egypt.




Floating Exchange Rate Systems

1. Managed Float – This is the system that we are currently following in India.

Exchange rate is free to float but under constant watch of Central Bank (RBI). It

generally intervenes only on occasions when there are wild movements. It basically

acts as stabiliser.

2. Independent Float – In this system Govt is just not bothered which way its

currency is moving. This is the system followed by rich and advanced countries like

USA, Kuwait, Saudi Arabia, etc.

India followed Fixed Peg System since independence. Indian rupee was pegged against UK

₤. In 1966, rupee was devalued. In 1975, India moved away from ₤ parity and pegged its

rupee against an unknown basket of 5 currencies. It devalued rupee once again during the

Balance of Payment Crisis in 1991. From 1993, we started following floating rate exchange

system.

Impossible Trinity (The three events that can not occur together)

(a) Having Fixed Peg system of Exchange Rate.

(b) Having complete convertibility on current and capital account.

(c) Having complete independence in deciding monetary policy.

No country to date has ever been able to achieve all the three conditions together at

any point of time. That is why it is called impossible trinity.

Why did economies of Argentina, Chile and Mexico crash?

Argentina Economic Crash – 2001

Argentina had been having a see saw economy ever since the beginning of 20th

century. It

was the 4th

largest economy in early 1915, fell down drastically in late 70s & 80s and then

again recovered to become 56th

economy in 1996. It suffered its first crash in 1929 during

American Stock Market Crash. It recovered from there to become 15th

largest economy

only to suffer yet another crash in 1970s and 1980s. In 1980, the inflation was as high as

5000%. In a matter 22 years, ie between 1970 and 1992, money got devalued by 10 billion

times. Yes! 10 billion pesos were reduced to a single peso.

Economic reforms launched in 1991 reduced inflation from 2300% in 1991 to just 1% in

next few years. However, the recovery was short lived. Some wrong currency policies of

Govt and economic crisis in countries like Mexico, Brazil and Russia, triggered another

economic crisis in 2001.

In 1991, a currency stabilization regime established a currency board, which pegged the

Argentine peso to the dollar on a 1-to-1 basis. Inflation was virtually eliminated. Foreign




investment returned. GDP growth was strong in the early 1990s, but unemployment

increased as a result of extensive structural reforms. Argentina finally seemed to have a

handle on its chronic economic problems. However, external events in the late 1990s

buffeted the Argentine economy:

1995: Mexico

1997: East Asia

1998: Russia

1999: Brazil

Because of its long history of economic instability, every economic crisis in the Third

World, particularly in Latin America, caused investors to pull out of Argentina, creating a

self-fulfilling prophesy. It was investors’ hair-trigger reaction to crises elsewhere that

caused Argentina’s instability, Thus, the adverse effects of these crises were greater in

Argentina than in most other new-growth economies. Another reason for this enhanced

vulnerability is that Argentina stood alone with its fixed-exchange-rate policy, whereas the

floating currencies of its neighbours depreciated. By 2001, the peso was significantly

overvalued, in no small part due to the dollar itself having become overvalued. The

devaluation of the Brazilian real had a particularly large effect. It reduced demand from

Argentina’s largest trading partner, and businesses began to move from Argentina to Brazil

in search of lower production costs. As the credibility of the peso at its pegged value

declined, and the government had to expend huge sums to support the currency, which in

turn necessitated more borrowing. Under these conditions, interest rates that were already

high rose even higher, and as both debt and interest rates rose, the ability of the government

to service its debt became increasingly doubtful. Argentina continued to keep the peso

pegged to the dollar by external borrowings.

The buzzards came home to roost in December 2001. The nation rapidly descended into an

unprecedented chaos. As economic activity shuddered to a virtual halt, governments

resigned and were hastily replaced amid sporadic rioting. The following month, when

Eduardo Duhalde (the fifth person to hold the presidency in two weeks) unpegged the peso

in January 2002, the peso crashed hard, losing more than 70% of its value and inflation

rising to 41% though it was still far far better than the expectations of four digit hyper

inflation experienced in late 80s decades. But inflation had fallen back to 3.2% by 2003.

So, we know now what agony was the country saved from by the much maligned and ever

pouting Mr PV Narsimha Rao, who displayed the rare courage to stand up against the

economically blind political class of the country (including his own party men) in

appointing Mr Man Mohan Singh as Finance Minister; and the practical economist Mr Man

Mohan Singh himself, whose economic prescriptions to cure the ills of the economy were

as effective as any measures ever were any where in the world in its modern history.




Mexican Economic Crisis

Mexican Economic trouble of 1994 was not a ‘Crash’ but a Crisis as it lasted just 10

months and the melt down was not as spectacular as in Argentina. This crisis was also

triggered by wrong currency policies of the govt. In Dec 1994, Mexican Peso fell from the

pegged rate of 3.3 peso to a dollar to 7.7 peso.

Though the crisis was triggered by; first: the devaluation of currency in December 1994

and second: floatation of currency soon after; the seeds were sown earlier.

Mexico had a fixed exchange rate of 3.3 peso to a dollar. In 1994, as the general election

drew near, the incumbent govt went into a spending blitz (politicians are same every where). As

a result, current account deficit ballooned to a record of 7%. In order to fund the spending,

the govt issued bonds repayable in dollars. High current account deficit and fixed exchange

rate led to over valuation of Peso by approximately 20%. Some investors were alarmed;

other smelled the opportunity; and together they quickly encashed the bonds in dollars.

Foreign exchange reserves fell drastically. Declining reserves necessitated devaluation of

currency. However, political compulsions did not allow this simple but hard prescription

till the incumbent govt lasted.

Next Govt which took over power in Dec 1994, devalued the currency to 4 pesos to dollar.

That did not prove adequate and within days peso was allowed full float which led to

crashing of peso to 7.2 pesos to a dollar.

Mexico’s immediate neighbour, USA, intervened immediately by first buying pesos from

open market and then arranging a loan of US$ 50 billion. The currency then stabilized first

at 6 pesos to a dollar and thereafter gradually declining over next two years to 7.7 dollars

before beginning a regular recovery. Mexico repaid all loans by 1997.




27 Jul 2006

FOREX MARKET AND FOREX ARITHMETIC

Forex market is open almost 24 hrs a day. It starts in Tokyo and ends in West Coast of

USA. By the time it closes in USA West Coast, it is within 2.5 hrs of opening of Tokyo

market for the next day.

Total trade in the Forex market is to the tune of over US$ 5 trillion per day. The Indian

Forex Market turnover itself averages US$ 5-10 billions/day.

Communication System – Forex Market has a dedicated worldwide telecommunication

network called SWIFT (Society for Worldwide Interbank Financial Telecommunications).

Forex Dealers

There are two kinds of forex dealers in the market:

(a) Full Fledged Money Changers – Mostly designated banks and Thomas

Cook (an exception). These are the authorized dealers who are permitted to

take positions. An authorized dealer deals in millions of dollars each day.

They can go long or short (overbought or oversold positions). They are also

allowed to appoint their franchisees.

(b) Restricted Money Changers – These are the kind of money changers who

line up the streets in tourist centres. They can only buy forex. They are not

allowed to sell. They are essentially convenience centres for tourists for

currency exchange.

One peculiarity of Forex Market is that it is mostly unregulated and completely driven by

the Demand-Supply principal. There are few benchmarks. Rates fluctuate minute by

minute, dealer by dealer, and customer by customer. There is nothing fixed. Two people

doing a sell deal with the same dealer at the same time in the same place and of same

currency may end up with vastly different rates. Money changers are free to quote their

own rate for buying and selling any currency (technically called Bid and Ask rates

respectively) based on customer, size of deal, their own current positions, etc.

How to make a Quote?

All money changers are connected to Reuters through SWIFT. The Reuters screen

continuously flashes current going rate for various currencies at different centres. However,

the rates are only indicative. They are representative rates for market as a whole. Individual

rates with various dealers vary.




Exchange Rates are quoted in following format: -

USD/INR = )(

)( 9000.46/8000.46 AskRate

BidRate

Above represents amount of currency in denominator (here INR) to be paid for each unit of

currency in numerator (here USD). Quotation is always in double numbers with minor

difference between the two. First number is called the Bid Rate and second number is

called Ask Rate. Bid rate is always lower than the Ask Rate.

Bid Rate is the rate at which the money changer is willing to buy a particular currency.

Ask Rate is the rate at which the money changer is willing to sell same currency.

Spread – As stated earlier, there is always a positive difference between Ask Rate and Bid

rate. This difference is called Spread and it is the profit margin that the dealer earns by

trade.

Spread = Ask Rate – Bid Rate

Spread % = 100

BR

BRAR

Forex market behaves like any other commodity market. Here too, there is whole sale and

retail market.

Whole sale market consists of Authorised Dealers and Big Corporate Houses like TCS,

Infosys and Wipro who have high forex exposures. But spreads in whole sale market are

lower.

Retail Market is populated by money changers, ordinary citizens, small exporters and

importers and small corporates.

Positions

In any financial market, two positions can be taken

(a) Long or overbought position and

(b) Short or oversold position.

Why are positions created?

Positions are taken in anticipation of currency exchange rate movement in one direction.

If a position is taken and the trend appears to be reversing (currency depreciates against

expectation of appreciation or vice-versa), the positions are liquidated by manipulating the




Bid and Ask rates. Example - If it is a long/overbought position, both Ask and Bid rates

will be lowered. Similarly, if there is an oversold position, both Ask rate and Bid Rate will

be hiked.

The quotations are normally in four decimal places. If a dollar is being quoted against

Rupee, it will be quoted as follows: -

46.5230/46.5250

First figure of quote is Bid Rate and second figure is Ask Rate. Third and fourth decimal

places are called PIPS. Thus, in the above case, 30 and 50 are pips.

In most cases, quotations are abbreviated to give only two or three digit pips in place of

Ask Rate. Thus, above quote could also be represented as: -

46.5230/50

Inter dealer quotes are further abbreviated to only three digit pips on both sides since base

rate of up to first decimal place is common across all dealers and therefore assumed to be

known.

Arbitrage

As in any other trade, arbitrage opportunities exist in Forex trade also. Arbitrage is

basically taking advantage of rate differential at two locations or markets or sources. For

instance, Bid (Buying) Rate of one dealer may be higher than Ask (Selling) Rate of another

dealer. A smart operator can buy from second dealer and sell to first dealer and earn some

money. This transaction is called Arbitrage. Let us see the above process in numbers.

Dealer A Dealer B

46.5030/46.5080 46.5090/46.5095

In the above case, Bid Rate of Dealer B (46.5090) is higher than Ask Rate of Dealer A

(46.5080). If a person Buys one million dollars from Dealer A and sells to Dealer B, he

earns - 0.0010 x 1,000,000 = Rs 1000

This is also called Single Point Arbitrage since there is only one Buying and Selling

operation involved. It normally happens when the deal is in single market involving two

dealers

Inverse Quote – Also called “Indirect Quote”. Normally, value of other currency is quoted

in local currency, ie, amount of local currency to be paid for each unit of foreign currency.

In India, all currencies are quoted using INR as the base, ie, value of other currency is

quoted in Indian Rupees. Similar practice is adopted by all other countries, using their local




currency as base and indicating number of local currency to be paid for each unit of other

currency.

Thus, a person will obtain USD/INR quote = 46.3020/46.3090 from a dealer in India and

INR/USD quote = 0.0213/0.0224 from another dealer in USA (US currency is used as base in

USA. So, the quotation will be number of USD to be paid for each INR). If the bases of quotes are

different, how do we compare the quotes? Comparison of two quotes becomes difficult.

Therefore, there is a need to INVERSE one of the quotes so that the base is common.

USD/INR = 46.3020

Inverse the quote

INR/USD = 0216.0 46.3020

1

)/(

1

INRUSD

That was a simple case when only mean rate is given. Now let us see what happens

when bid and ask rates are quoted.

USD/INR = 46.3020/46.3090

021597.046.3020

1

)/(

1

BIDASK INRUSDUSD

INR

021594.03090.46

1

)/(

1

ASKBID INRUSDUSD

INR

(Please note that for finding BID rate, we have to inverse ASK rate and for finding ASK rate we have

to inverse BID rate. What is the logic for this?

Currency trade is basically a BARTER trade. In any other trade, commodity is traded against a

currency. However, in currency trade, both sides have currencies but of different type. It is like one

side having wheat and the other side having rice and both ready to exchange their commodity for the

other’s for a negotiated exchange rate. In such a situation there is no seller and no buyer. Saying it

other way round, both are sellers and both are buyers. When one buys other’s commodity, he

simultaneously sells his commodity. So, when one trader says – I am willing to sell one dollar for

Rs 47, it can also be interpreted as - he is willing to buy Rupee for 1/47 dollar. Thus, his ASK rate

of Rs 47 for a dollar has become his BID rate for a Rupee in inverse quote at 1/47 dollar. Therefore,

when currency quotes (exchange rates) are inversed, Bid and Ask rates also have to be inversed).

Two Point Arbitrage – When two locations are involved in the dealing, it is possible to buy

a currency from one location/market and sell it in other market and earn arbitrage. For

example, some one can purchase dollars in India and sell them in US market for Rupee.

This is called Two Point Arbitrage.

Three Point Arbitrage – Some times Arbitrage opportunity is available by currency

exchange operations across two or three markets. In such an operation, first one currency is

purchased in one market and then sold in second market for a third currency. Third




currency is then sold in third or first market for original currency.

Suppose, there are three currencies A, B and C. Quotes are available for A/B, B/C and C/A

(C/A)BID = (B/A)BID X (C/B)BID

ASKASK

BIDCBBA

AC)/(

1

)/(

1)/(

AND

(C/A)ASK =(C/B)ASK X (B/A)ASK

BIDBID

ASKBACB

AC)/(

1

)/(

1)/(

Forward Quotes

Forward quotes are one where a dealer quotes for purchase and selling of forex at a future

date. These quotes are mainly useful for exporters and importers who commit to sell their

ware or import goods based on exchange rate prevailing on that date. However, money is

received or paid in foreign currency at a much later date. Any large adverse movement of

exchange rate in the interim can lead to heavy losses. Therefore, importers and exporters

cover their risk by utilisation of these forward quotes. Various terminologies associated

with forward quotes are as follows:

Spot Deal – Settlement on T+2 days (‘T’ refers to Transaction Date. Thus, delivery of

forex and payment of cash for a transaction done on Monday has to be completed (settled)

by Wednesday)

Spotcash Deal – Settlement on T + 0 days (Same day payment and delivery)

SpotTom Deal – Settlement on T + 1 Day (Next Day Payment)

Forward deals could be T+10, T + 30, T + 90, etc. (Add 2 working days for each settlement).

Inter Dealer Forward Quotes are not elaborate. Only differential amount to spot deal rates

are quoted. Thus, if

If GBP/INRspot = 85.8680/85.8950

Then, 30 days FP (Forward Premium) is quoted as 30/40, which means

30 days FP for GBP/INRspot = (85.8680 + 0.0030) / (85.8950 + 0.0040)

= 85.8710/85.8990




It is possible that Bid FP for a Forward Quote is higher than Ask FP. If such a situation

occurs, it means that local currency is expected to appreciate. If local currency appreciates,

for each unit of foreign currency, lesser amount of local currency would be paid. Thus, in

such a situation, the quoted differential amount is decreased rather than added to Spot

quotes.

In the above example, if dealer quotes were 40/30, then 30 days FP would be:

30 days FP for GBP/INRspot = 85.8680 - 0.0040 /85.8950 - 0.0030

= 85.8640/85.8920

In the Forward Deals there are more variations –

Out Right Forward Deal – A deal where there is only one transaction of sell or buy at a

future date. So, you decide to buy one million dollars after 60 days.

Spot Forward Deal – A deal where there is a Spot Deal and a covering deal on a future

date. So, you buy one million dollars today and strike a forward deal for selling one million

dollars after 60 days.

Forward Forward Deal – There is a Buy and a covering Sell deal on a future date (future

dates of buy and sell deals are different). So, you do a forward deal to buy one million

dollars after 30 days and do another forward deal to sell one million dollars after 45 days.

Broken Date/Forward Rate Calculation

Quotes are available for one month, three months or six months. There may be requirement

to calculate for a date in between these quoted dates, say for 1½ months or 3 months and 25

days. Such calculations are done by intrapolation of quotes for available dates

(extrapolation is never done for dates beyond max quote). Let us take an example for

conceptual clarity:

Spot USD/INRSpot = 46.8000/46.9000

1 month FP = 50/80

3 months FP = 100/200

6 months FP = 200/300

Find forward rates for 1 month 15 days and also for 3 months 25 days.

Ans. For 1 month 15 days =

daysdays

daysdays

1560

80200

1560

50100

(“60” because 3 months minus 1 month = 60 days)




= 30

13

= 46.8050 + .0013 / 46.9080 + 0.0030

= 46.8063 / 46.9110

For 3 month 25 days =

daysdays

daysdays

2590

200300

2590

100200

= 70.27

7.27

28

28

= 46.8100 + .0028 / 46.9200 + 0.0028

= 46.8128 / 46.9228

Forward Premium/Discount Computation

FP = 10012

nSR

SRFR

MR

MRMR (MR means Mid Rate which is average of Bid and Ask Rates)

If FP is (+)ve, then foreign currency is appreciating

If FP is (–)ve then forward deal is at a discount which means that local currency is

expected to appreciate.

Spot USD/INR = 46.8030/46.8500 Mid Rate = 46.8265

3M FR = 46.9030/46.9500 Mid Rate = 46.9265

n = 3 months

Forward Premium = 1003

12

46.8265

46.8265- 46.9265

= 0.8542 Thus, there is a 0.85% premium on forward quotes.

In case the result was in negative, then there was a discount, which means that foreign

currency is going to depreciate and local currency is expected to appreciate.

Factors Affecting the Forex Forward Quote

1. Inflation – The currency of the country experiencing higher inflation rate will

depreciate in value




2. Interest Rate – Capital will move from low interest rate country to higher interest

country. Thus, currency of country with higher interest rate will appreciate due to

higher demand.

Forward Rate =

RF

RD

I

ISpotRate

1

1

Where

IRD = Interest Rate in Domestic Market

IRF = Interest Rate in Foreign Market

Interest Arbitrage

Interest Arbitrage refers to the international flow of short term liquid capital (Fixed

Deposits denominated in Foreign Currencies or Convertible local currency) to earn a higher

interest abroad. In India, we have NRIs investing in fixed deposits to earn higher interest

rates. Interest arbitrage can be uncovered or covered.

Uncovered Interest Arbitrage

In order to be able to take benefit of higher interest opportunity in foreign country, it is

often necessary to convert the domestic currency to foreign currency while investing in

foreign country and then reconverting principal and interest earned to local currency at the

time of maturity.

In countries where interest rates are higher, inflation is also higher. (nominal interest rate is

mostly equal to real interest rate + inflation). When inflation is higher, the currency mostly

depreciates over time. Thus, there is a risk of depreciation of investment due to lower

exchange rate during the re-conversion after maturity. If such a foreign exchange risk is

covered through forward, we have covered interest arbitrage, else, we have uncovered

interest arbitrage.

Suppose, interest rate in India is 11% where as it is 5% in US. A US investor will earn 6%

extra per year or 3% every 6 months if he invests in India. However, since inflation rate is

also high in India at 5% compared to just 2% in US, INR is likely to depreciate. If INR

depreciates by 3% over one year, net return on investment by US investor falls to barely

3%. However, in case INR depreciates by more than 6%, the US investor will end up as net

loser (and we have not even considered the transaction costs in conversion and reconversion processes).

Covered Interest Arbitrage

The scenario given above is not beyond real life events. In order to insure against exchange

rate risks, investors usually go for covered interest rate arbitrage.

In this case, investor converts his investment into foreign currency at spot rate and at the




same time sells forward the amount of foreign currency he is investing plus the interest he

would earn to coincide with maturity date of investment. Though, he would be paying

some premium for forward cover, he is insured against depreciation of currency. His return

on investment will reduce by the amount of premium paid for forward deal compared to

uncovered interest arbitrage, but that is the price to be paid for insurance.

But such opportunities do not last long due to two reasons.

(a) As funds move out of the home country, the interest rates rise there due to

resultant paucity of funds. Vice versa, as additional funds flow in to foreign

country, excess liquidity of capital causes interest rates to soften there.

(b) As demand for forward deals on currency of other country rise, premium on

forward deals increases. Thus, the cost of transaction (conversion and

reconversion of currency) increases and eats into profits to be earned from

interest rate arbitrage.

Thus, the interest rate differential keeps reducing and forward premium keeps

increasing till it comes to a level where it is no more advantageous to invest in foreign

country.

Problem 01

Exchange rate for USD in India is

Spot: 45.0020

6 month forward: 45.9010

Interest rate (annual) in the money market is as follows:

USA: 7%

India: 12%

Work out the arbitrage opportunity.

Solution

Given Spot USD/INR = 45.0020

6 Months Forward = 45.9010

Interest Rate USA = 7% and India = 12%

Forward Rate =

RF

RD

I

ISpotRate

1

1

=

12

6

100

71

12

6

100

121

0020.45




= 45.0020 x (1.0241)

= 46.0890

& the Forward Market Rate = 45.9010. Thus, there is an opportunity for arbitrage.

Annualised Forward Premium = 10012

nSR

SRFR

MR

MRMR

= 1006

12

0020.45

0020.459010.45

= 3.995%

USD is going at a premium of 3.995%.

As per the interest rate differential, USD should be quoted at INR 46.0890. Also, Interest

Rate Differential between two countries = 12 – 7 = 5%, where as, USD is being quoted at a

forward premium of only 3.995%. Thus, there is an opportunity to borrow USD from USA

@ 7%, convert to INR and invest in treasury bond at 12% while simultaneously buying

USD 6 months Forward @ 45.9010 and earn an arbitrage of 1.005% on investment.

Scenario II

If forward rate was 46.9010

Then premium = 1006

12

0020.45

0020.459010.46

= 8.44%

Thus, if you invest in INR, you would make a loss of 8.44% in forward deal where as your

earning from interest would be 12 – 7 = 5%. Thus, you be in net loss of 8.44 – 5 = 3.44%.

This kind of transaction is possible only when Govt gives freedom to buy and sell INR or

USD in both countries.

Now in this case, borrow INR 45.0020 in India @ 12% and convert to 1 USD at spot rate.

Invest this USD in money market in USD at 7% for six months. Simultaneously, sell USD

1.035 in 6 months forward for INR 48.5425. Your liability against borrowing in India =

12

6

100

12110020.45

= 47.702

Thus, there would be gain of INR 48.5425 - 47.702 = INR 0.8405 per INR 45.0020




invested or 3.44%.

Problem 02

In April 2005, USD/ INR quotes were 43.70/44.05.

6 months Swap points were 40/70

Annual Interest Rate in USA and Indian were 2% and 8% respectively.

Work out the scope for arbitrage, if any.

Solution.

Spot Rate USD/INR : 43.70/44.05

Fwd Rate (Six Months) : 43.70+0.40/44.05+0.70

= 44.10/44.75

Annual Interest Rates in USA and India are 2% and 8%.

For buying USDfwd, Premium = 1006

12

Rate Bid

Rate Bid - RateAsk

Spot

SpotFwd

= 1006

12

43.70

43.70 - 44.75

= 4.80%

(Method for deriving above formula : Proceed as per following logic. Start with buying forward for currency

of country where interest rate is low. You want to buy forward because you need to pay in future in that

currency. You need to pay in future in that currency because you borrowed today in that currency. Once you

have borrowed that currency, you will sell that currency in spot market and buy other currency. That gives

the base, either Bid Ratespot or Ask Ratespot. Put this at denominator. Put same figure as “value to be

subtracted” in numerator. Put complementary value of subtracted value as first figure, like, for Bid RateFwd

Ask RateFwd and for Ask RateFwd Bid RateFwd. That completes the formula. In case you want to work out

formula for forward of other currency, simply inverse all the Ask for Bid and Bid for Ask).

So, Formula for buying INRFwd, Premium = 1006

12

Spot

SpotFwd

RateAsk

RateAskRateBid

Interest Rate Differential = 8 – 2 = 6%

Thus, while we lose 4.8% in forward market, we earn 6% in money market. Thus, net gain

is 6 – 4.8 = 1.2%.

Start with USD 100 borrowed from US market @ 2% and convert to INR @ 43.70 to INR

4370. Invest this money in Indian market @ 8% and get 4370 x 1.04 = INR 4544.80. Buy

USD forward @ 44.7 for INR 4544.80 and get USD 101.56. Pay USD 101 to US market




and keep USD 0.56 as covered interest arbitrage profit.

Interest Rate Differential, Covered Interest Arbitrage and Interest Parity Theory

3

2

Arbitrage

1

0

-1 .

.

-2

-3

-3 -2 -1 0 1 2 3 Forward Exchange Rate – Discount or premium in percent per annum

Explanation of the above figure

Arbitrage Outflow will take place

1. If (+)ve interest rate differential is > Forward Discount like at Point A, Interest Rate

Differential = 2, and Fwd Discount = 0.5

2. If Forward Premium > (–)ve Interest Rate Differential like at Point A’,

Fwd Premium = 2.2, and Interest Rate Differential = - 1.05

Arbitrage Inflow

3. If Forward Discount > (+)ve Interest Rate Differential, like at Point B,

Fwd Discount = 2.7, and (+)ve Interest Differential = 1.2

4. If (–)ve interest Rate Differential > Forward Premium, like at Point B’,

–ve Interest Rate Differential = 2.2, and Forward Premium = 0.7

Arbitrage

Outflow

Arbitrage

inflow

.A’

.B

A

Inte

rees

t D

iffe

ren

tial

in

fav

our

of

fore

ign

co

un

try

in

per

cen

t p

er a

nnu

m

Interest

Parity

B’




Sample Practice Questions on Exch Rate (Forex Arithmetic)

Q1. The Spot Rate of two banks in US Market for GBP is as follows:

GBP/USD: Bank A: 1.4550/1.4560

Bank B: 1.4380/1.4548

Find Whether Arbitrage is possible.

Ans. Bank B 1.4380 1.4548

Bank A 1.4550 1.4560

The Ask Rate of bank B for selling a GBP is USD 1.4548 which is less than Bid Rate of

bank A at 1.4550. Thus, it is possible to buy GBP from bank B and sell to bank A and earn

an arbitrage of USD 0.0002 for each GBP traded. In the above diagram, the triple line in

green indicates the arbitrage opportunity. If the two lines, double line and solid thick line

had overlapped, then there was no arbitrage opportunity.

Q2. Rate for USD in Indian Market is as follows:

USD/INR: 46.2000/3000

Inverse the quotes.

Ans. 2000.46

1

/

1/

BID

ASKINRUSD

USDINR

= 0.021645

3000.46

1

/

1/

ASK

BIDINRUSD

USDINR

= 0.021598

Q3. In the Forex Market, following are the rates:

USD/JPY: 110.25/111.10

USD/AUD: 1.6520/1.6530

AUD/JPY: 68.30/69.00

Find Whether Arbitrage is possible in terms of AUD/JPY.

Ans. In this case, if we inverse the rate of USD/AUD and get AUD/USD, our job will

become easy.

6050.06530.1

1

/

1/

ASK

BIDAUDUSD

USDAUD




6053.06520.1

1

/

1/

BID

ASKAUDUSD

USDAUD

AUD/JPY = AUD/USD X USD/JPY

(AUD/JPY)BID = (AUD/USD)BID X (USD/JPY)BID

2533.6710.1116520.1

1/

6969.6625.1106530.1

1/

ASK

BID

JPYAUD

JPYAUD

By Three Point Arbitrage - AUD/JPY = 66.6969/67.2533

Forex Market Rate for AUD/JPY = 68.30/69.00

Thus, there is a difference of almost one JPY for each AUD in two situations.

So, to earn arbitrage, Sell JPY and buy USD @ 111.10.

Then sell USD and buy AUD @ 1.6520. Now sell 1.6520 AUD and buy JPY @

JPY 68.3 for AUD 1.

83.11230.686520.1

Thus, for every JPY 111.10 put into market, there is a return of JPY 112.83.

Q4. Following are the quotes in New York:

GBP/USD: 1.5275/85

USD/CHF: 1.5530/39

(a) What rate do you expect for GBP in Basle?

(b) If Basle quote is 1GBP = 2.3320/30 CHF, then find whether Arbitrage is

possible?

Ans GBP/USD: 1.5275/85, USD/CHF: 1.5530/39

CHF

GBPCHF

USDUSD

GBP

3751.2

3722.2

5539.1

5530.1

5285.1

5275.1

3751.23722.2

CHFGBP

Basle Quote = 1GBP = 2.3320/30 CHF

GBP is cheaper to buy in Basle at 2.3330 CHF. Therefore, buy one GBP in Basle




and sell in New York for USD 1.5275. Then sell USD 1.5275 for 2.3722 CHF and earn an

arbitrage of (2.3722 - 2.3330) = 0.0398 CHF per GBP or

2.3722 CHF = 3722.23330.2

1

= 1.0168 GBP

So, the Arbitrageur will make GBP 0.0168 for every GBP traded.

Q5. Following are the EUR/INR quotes:

Spot: 49.9525/80

1 Month Forward: 100/120



Find absolute forward quotes.

Ans. 1 Month Forward: 49.9625/700

3 Month Forward: 49.9750/835

6 Month Forward: 49.9225/305

Q6. A bank is quoting following rates:

EUR/USD: 1.5975/80

2 Month Forward Points :20/10

3 Month Forward Points: 25/10

Further,

AED/USD rate is 3.7550/60

2 month forwards points: 20/40

3 month Forward points: 30/50

A firm wishes to buy AED against EUR 3 month forward. Find the rate to be quoted by

the bank.

Ans. AED/USD = 3.7550/60

3 months Forward Rate = 3.7580/610

EUR/USD: 1.5975/80

3 months Forward Rate = 1.5950/70

BID

ASKUSDEUR

EURUSD/

1/

5950.1

1/ ASKEURUSD

62696.0




ASK

BIDUSDEUR

EURUSD/

1/

62617.0

5970.1

1/

ASKEURUSD

EUR

USD

USD

AED

EURAED

3532.2

62617.07580.3

BIDBID

BID EUR

USD

USD

AED

EURAED

3572.2

62696.07610.3

ASKASK

ASK EUR

USD

USD

AED

EURAED

So, AED/EUR = 2.3532/80

Money Market Hedging

Q1. An American Exporter will be receiving ₤ 1,000,000 three months from now. Spot

Rate for GBP/USD = 1.6 Rate of interest in USA and London Money market is

10% and 5% respectively. Suggest hedging strategies for the exporter.

Ans: Exporter should borrow ₤ 987,654 from London Money Market @ 5%, convert to

USD 1,580,247 and invest in US for 3 months @ 10%. After 3 months he will get

USD 1,580,247 + 39,506 = USD 1,619,753 and will need to pay ₤ 1,000,000 which

he can when he receives his payment 3 months later. Thus, he earns USD 19,753 as

arbitrage. There is no need to hedge the position for his borrowing with a forward

cover since he has natural hedge in terms of earning.

Q2. An American importer has to pay ₤ 1,000,000 to a party in London 3 months from

now for the denim import it has made. The Spot rate for GBP is 1.6 USD. It is

expected that USD may depreciate further in future. Rate of Interest in USA is 5%

and in UK it is 10%. Suggest hedging strategies for importer.

Ans: This is a slightly peculiar case. Normally, the currency of country where interest

rate is high, depreciates. But in this case USD is expected to depreciate despite US

interest rates being lower. But that makes the job of importer much easier.




The American importer needs to pay 1.6 x 1,000,000 = USD 1,600,000 at

current rates. Since he needs to pay 3 months later, and USD is expected to

depreciate in the meanwhile, he can convert USD to GBP now and invest in UK @

10% per annum. He will earn 2.5% interest in 3 months. To be able to have GBP

1,000,000 three months from now, he should invest GBP 1,000,000/1.025 = GBP

975,610 now. GBP 975,610 = USD 1,560,976.

So, he should borrow USD 1,560,976 and convert to GBP and invest in UK

market @ 10%. Three months later, he will get GBP 1,000,000 (principal + interest)

and pay his liability. In US, he will have to pay only USD 1,580,488 to bank

instead of USD 1,600,000 and thus save USD19,152 as arbitrage. His position has

been also hedged simultaneously.

Interest Rate Arbitrage

Q3. A Customer obtains following quote-

EUR/USD: 1.2930/1.3270

Annual USIBBR/US IBOR: 4/5.5%

Annual LIBBR/LIBOR: 6/9%

Calculate the likely limits for the Forward Rate between the two countries.

Ans: Suppose you borrow USD 1.3270 @ 5.5% for one year. Your liability after one

year = 1.3270 + 5.5% = USD 1.4000. Convert this USD 1.3270 to EUR 1.0000 and

invest in bank @ 6%. You will earn EUR 1.0600

Sell EUR 1.0600 in Forward market. Bid Rate should be such that your money does

not fetch you more than your liability for payment (USD 1.4000 in this case)

So, 1.06 x ForwardBid ≤ 1.4000 Thus, Forward EUR/USDBid ≤ 1.3208

Now take the Reverse Arbitrage

Borrow EUR 1 @ 9% for one year. Your liability after one year = EUR1.0900

Convert (sell EUR) this EUR 1 to get USD 1.2930 and invest in bank @ 4%.

You will earn USD 1.34472. Using this USD 1.34472, buy EUR in forward market.

Forward EUR/USDAsk rates should be such that it yields you less than your liability

(EUR 1.0900 in this case).

1.34472 / FR ≤ EUR1.0900, or FR ≥ 1.34472 / 1.0900

Forward EUR/USDAsk ≥ 1.2337

Ask rate should always be higher than Bid Rate and forward spread should be more

than spot spread. Spot spread is 0.0340. If we increase the spread by another 10

points, ie, 0.0350 and add to Bid Rate. We get the range as

Forward EUR/USDAsk = 1.3208/1.3558




FOREX RISK MANAGEMENT THROUGH FUTURES

A future is an exchange-traded derivative which is similar to a forward. Both futures and

forwards represent agreements to buy/sell some underlying asset in the future for a

specified price. Both can be for physical settlement or cash settlement. Both offer a

convenient tool for hedging or speculation. For little or no initial cash outlay, both

instruments provide price exposure without a need to immediately pay for, hold or

warehouse the underlying asset. In this sense, both instruments are leveraged. Futures and

forwards trade on a variety of underliers: wheat, oil, live beef, Eurodollar deposits, gold,

foreign exchange, the S&P 500 stock index, etc.

The fundamental difference between futures and forwards is the fact that futures are traded

on Exchanges. Forwards trade over the counter. This has three practical implications.

1. Futures are standardized instruments. You can only trade in the specific contracts

supported by the exchange. Forwards are entirely flexible. Because they are

privately negotiated between parties, they can be for any conceivable underlier

(currency) and for any settlement date. Parties to the contract decide on the notional

amount and whether physical or cash settlement will be used. If the underlier is for

a physically settled commodity or energy, parties agree on issues such as delivery

point and quality.

2. Forwards entail both market risk and credit risk. A counterparty may fail to perform

on a forward. With futures, there is only market risk. This is because exchanges

employ a system whereby counterparties settle profits or losses on daily basis.

Through these margin payments, a futures contract's market value is effectively

reset to zero at the end of each trading day. This all but eliminates credit risk.

3. The daily cash flows associated with margining can skew futures prices, causing

them to diverge from corresponding forward prices.

A future is transacted through an authorised brokerage firm. Working through their

respective brokers, two parties will transact a trade. Legally, that trade is structured as two

trades, both with a clearinghouse owned by or closely affiliated with the exchange. For

example, suppose Party A and Party B trade. Party A is long and Party B is short. This

would be legally structured as

Party A being long on One million USD futures at Rs 47 with the

exchange's clearinghouse being the counterparty; and

The exchange's clearinghouse being long on One million USD futures at

Rs 47 with Party B being the counterparty.

Party A and B then have no legal obligation to each other. Their respective legal

obligations are to the exchange's clearinghouse. The clearinghouse never takes market risk

because it always has offsetting positions with different counterparties.

http://www.riskglossary.com/articles/notional_amount.htm

http://www.riskglossary.com/articles/notional_amount.htm




Before you can trade a futures contract, the broker collects a deposit from you called initial

margin. This may be in the form of cash or acceptable securities. The broker holds this

deposit for you in a margin account. The amount of initial margin is determined according

to a formula set by the exchange. For a single futures contract, it will be a small fraction of

the market value of the futures' underlier. For futures spreads, or if you are using futures to

hedge a physical position in the underlier, initial margin may be even lower. Generally,

initial margin is intended to represent the maximum one-day net loss you could reasonably

be expected to incur on a position.

Through the margining process, futures settle every day. Unlike a Forward, where all

contract obligations are satisfied at maturity, obligations under the futures contract are

satisfied every day on an ongoing basis as mark-to-market profits or losses are realized.

This essentially eliminates credit risk for futures.

Maintenance Margin is some fraction - perhaps 75% - of initial margin for a position.

Should the balance in your margin account fall below the maintenance margin, your broker

will require that you deposit funds or securities sufficient to restore the balance to the initial

margin level. Such a demand is called a Margin Call. The additional deposit is called

Variation Margin. Should you fail to make a variation margin payment, your broker will

immediately liquidate some or all of your positions.

Mechanism of Futures Trading

Components of Futures Trade

1. Futures Players

(a) Hedgers – These are the importers and exporters who mitigate their risk of

unfavourable movement of exchange rate when they need to buy or sell the

foreign currency at a future date.

(b) Speculators – These are investors who buy or sell foreign currency with the

sole aim of earning money through correct anticipation of movement of

exchange rate. Even though they are essentially gamblers, they are an

important component of market as they provide the liquidity and stability in

the market.

(c) Arbitrageurs – These are people who utilise the opportunities presented by

market due to asymmetric forex exchange bid and ask rates in the same

market or in different markets

2. Clearing Houses – Futures trade is an organised trade. Futures are traded through

exchanges akin to Securities Exchanges which provide performance guarantee for

all the players. They play the role of buyer for every seller and vice versa. Thus,

every trading party in the futures market has obligation only to the clearing house.




3. Margin Requirement – The risk of default of any player is insured by imposing the

requirement of depositing the margin money which is adequate to cover the adverse

movement of currency in the short term. Thus, margins are not uniform and vary

across markets, contracts, currencies and duration of contract. Since the currency

movement is not as wild as stocks, the margin requirement is also relatively small. (Usually in the range of 5% of contract value).

4. Daily Settlement – Notional losses or gains incurred due to fall in the value of the

currency are required to be settled between the party and the broker on daily basis

to ensure maintenance of original level of margin (security) money. This is

technically called “Mark to Market”.

5. Delivery Date – There are two types of contracts – European Contract, which are

delivered/encashed only on the last day of the contract period and American

Contracts, which can be delivered/encashed on any day during the contract period.

6. Manner of Delivery – The contract settlement, technically called “Delivery”, can be

done by either of the following three modes:

(a) Physical exchange of underlying assets ie Exchange of currencies.

(b) Cash Settlement as in the case of Stock Index Futures. There is no exchange

of currencies and only differential amount is paid.

(c) Reversing Trade - It is the process of offsetting a long position by acquiring

a short position or vice versa. The two positions square at the end of the day.

7. Types of Orders –

(a) Market Order – Order placed with broker to Buy or sell at prevailing market

price.

(b) Limit Order – Buy or sell order at a specific price or better.

(c) Fill-or-Kill Order – It instructs broker to fill an order immediately at a

specified price.

(d) All or none Order – It allows broker to fill part of the order at specified

price and remaining at other price/s.

(e) On the Open or Close Order – This represents order to trade within a few

minutes of opening or closing of the exchange.

(f) Stop Order – It triggers a reversing trade when prices hit a prescribed limit.

Functions of Futures Markets

Futures Markets function as –

1. Price Discovery Agent




2. Speculation Tool

3. Hedging Tool

Price Discovery

“Futures” prices are generally treated as a consensus forecast by the market of prices of

currency/commodity at the contract expiry date. Thus, for all and sundry, it is a free

forecast available to them. Empirical studies have revealed that such forecasts are not very

accurate, yet they are the best among all the alternatives available. More often than not,

they provide a reasonably good hint in case of currencies and commodities but not equally

accurately in case of stocks.

Speculation

Futures provide excellent tool for speculation since it is highly leveraged (only margin amount

of approximately 5% needs to be paid upfront). Also, the transaction costs are lower than in case of

delivery. Thus, percentage returns are higher.

Speculators are categorised based on the length of positions they hold.

(a) Scalpers – They have the shortest holding horizons, typically closing a

position within minutes of initiation.

(b) Day Traders – They hold futures positions for a few hours but never longer

than one trading session. They open and close positions within the same

day. Their net holding at the end of any day is always zero. They play on the

scheduled announcements and news related to money supply, trade deficit

etc.

(c) Position Traders – They have longer holding horizons, often a few months.

There are two types of position traders:

(i) Outright Position Holders – He takes position based on his belief

on the underlying potential. He stands to make large gains or losses.

(ii) Spread Position Holders – He does not have belief on a particular

currency or commodity, but he speculates on relative movement of

two commodities. So he holds simultaneous position in two

commodities, long in commodity which is likely to appreciate and

short in commodity which is likely to depreciate. The two

commodities could be from same basket, like wheat and rice or

could be from different baskets like wheat and Steel. If the spread

between them widens, he gains else he loses. Such positions are less

risky than Outright Positions.




Hedging

Hedging is process of engaging in a futures or forward contract by paying a small premium

to eliminate risk associated with large unfavourable movement in exchange rate by the time

payment or receipt is due. There are three types of hedges:

(a) Long Hedge/Anticipatory Hedge – Investor does not own the asset but

wants to purchase the same in foreseeable future. He protects against

adverse price movement of the large escalation in prices of that asset by

long hedge.

(b) Short Hedge – An investor already owns an asset which he wants to sell in

future. He wants protection against steep fall in its prices. He hedges the risk

by selling its future.

(c) Cross Hedge – The act of hedging ones position by taking an offsetting

position in another good with similar price movements. Although the two

goods are not identical, they are correlated enough to create a hedged

position. A good example is cross hedging a long position in crude oil

futures contract with a short position in natural gas. Even though these two

products are not identical, their price movements are similar enough to use

for hedging purposes. In currency matters, USD and Canadian Dollars can

be used for cross hedging.




FOREX RISK MANAGEMENT THROUGH OPTIONS

An Option is a contract which gives its buyer the right either to buy (Call Option) or to sell

(Put Option) a specified amount of a currency within/after a specified period at a

predetermined price called Strike Price. An Option that gives the right to buy is called a

Call Option and an Option that gives the right to sell is called a Put Option.

An option gives the buyer right to buy or sell but there is no obligation to do so. A buyer is

at liberty not to exercise his option. But the seller is under obligation to honour the call or

put option if the buyer decides to exercise it. And the buyer will do it only when it is

profitable to him. He will exercise his Call Option (right to buy) when market rate of that

currency is higher than the strike price. Similarly, he will exercise his put Option, only

when market price has fallen below the strike price.

Suppose, Mr Yashwant buys a Call Option from Mr Joseph @ INR 46 for USD 1,000,000

on 01 Sep 2006 with the expiry date of 30 Sep 2006. Now, Mr Yashwant can demand from

Mr Joseph to sell USD 1,000,000 on any day during this period. Mr Yashwant will want to

buy these USD from Joseph only if rate of USD in the open market is higher than strike

price of INR 46, say INR 47. In case, open market rate is lower than INR 46, say INR 45,

Mr Yashwant will be better off buying the USD from open market.

If USD rate goes up to INR 47 and Mr Yashwant demands to exercise his Call Option, Mr

Joseph will have to sell him those USD at strike price of Rs 46 which is now at a discount

of INR 1/- to the market price. However, if the market price had fallen below the strike

price to INR 45, Mr Yashwant is under no obligation to buy USD from Mr Joseph at Rs 46.

But why should Option Seller (also called Writer) take this risk? He sells the options for a

price called Premium which is non refundable. He hopes that option would not be

exercised and he would be able to keep the premium. In case an option is not exercised, it

is his earning. In case the option gets exercised, his loss is partly offset by this amount.

Speciality of Options contracts is that while max loss for the buyer of Option is limited to

the premium he paid for purchasing the contract, his profits have no limits. The situation is

just the reverse for the seller. His max profit is equal to the premium he has received but his

losses have no cap.

Option Contracts also follow the American and European systems. An option which can be

exercised at any time during the currency of the contract is called “American Style”

Option. Another type of Option which can be exercised only at the end of the contract

period is called the European Style. The probability of exercise of option is higher in case

of American Options and therefore the premium is also higher. Similarly, if the contract

period is longer, probability of exercise of option increases and the premium goes up again.

Another factor which affects the premium is the Strike Price. Farther the strike price from

spot price at the time of deal, lesser the probability of exercise and so lesser the premium.

An option can be “In the Money”, “At the money” or “Out of the money” depending upon

Strike Price vis a vis market price of asset.




An option is called “In the Money” if the exercise of option at that market price would

fetch him profit. So, in a Call Option, if the dollar’s spot price is INR 46, and strike price is

INR 44, exercise of option will fetch a profit of INR 2.00 per dollar.

An option is called “At the Money” if the spot price and strike price are equal and therefore

no gain or loss would accrue to either side (premium is not considered). Therefore, such

options are not exercised.

An option is called “Out of Money” if its exercise would lead to loss to the buyer, ie, in a

call option, the spot price of the USD falls below the strike price. Suppose, a dollar Call

Option was purchased for INR 44. If the spot price of dollar falls to Rs 43, it would be

cheaper to buy dollars from market than exercise of option. Therefore, “Out of Money”

options are never exercised.

Premiums are also influenced by following factors:

(a) Volatility – Higher the volatility, higher the chances of asset prices

breaching the strike price. So, higher the premiums.

(b) Interest Rate – Relative interest rate between two currencies affect

premiums.

(c) Political uncertainty, inflation, etc, again pose risk of sharp movement in

currency exchange rates and therefore premium.

Option Strategies

This flexibility and variability in pricing of options and premium give a multitude of

opportunities to the players in the market. By buying or selling a combination of options,

profit opportunities are created. Some of the strategies adopted by people are listed below: -

Naked Option – An option for which the buyer or seller has no underlying security

position. A writer of a naked Call Option, therefore, does not own the asset or even a Long

Position in the asset on which the call has been written. Similarly, the writer of a naked Put

Option does not have a Short Position in the asset on which the Put has been written.

Naked options are very risky-although potentially very rewarding. If the underlying asset

moves in the direction anticipated by the writer/seller, profits can be enormous, because the

investor would only have had to put down a small amount of money to reap a large return.

On the other hand, if the asset moved in the opposite direction, the writer of the naked

option could be subject to huge losses. It is also called uncovered option.

Straddle – An options strategy in which the investor holds position in both, a call and a put

with the same strike price and expiration date. Straddles are a good strategy to pursue as a

buyer if an investor believes that a stock's price will move significantly, but is unsure as to

which direction (volatile market). Since the buyer has invested two premiums (one each for

call and put), the stock price must move significantly if the buyer of option is to make a

profit. As shown in the diagram below, should only a small movement in price occur in




either direction, the buyer will experience a loss (due to premium he has paid for two contracts).

As a result, a straddle is extremely risky to perform. Additionally, on assets that are

expected to jump, the market tends to price options at a higher premium, which ultimately

reduces the expected payoff even when the stock moves significantly.

There is a Long Straddle in which the person buys call and put options simultaneously.

Short Straddle - If the market is expected to be stable, the person can sell the call and put

options at the same time. Thus, he will collect two premiums and may have to pay back

only a small portion of that amount if the asset price moves in a narrow band. This is called

a Short Straddle because he is selling without owning the asset.

Strangle –It involves buying a call and a put option at two different rates but of equal value

and of same maturity date.

In a Long Strangle, Call is bought at a lower rate and Put is bought at higher rate. Long

Strangle is again a strategy for a volatile markets.

In the short Strangle, Call is sold at higher rate and Put is sold at lower rate. Short Strangle

is used for stable markets.

In case of straddle, if the market is not volatile, purchaser loses the premium on both the

Selling a Put Selling a Call

46

45.50 46.50 Pro

fit

Loss

A Put Option Short Straddle




sides. But this is not the case in Strangle.

Take a hypothetical case where a Long straddle has been entered into with Put Option

purchased at Strike Price of INR 47 and a Call Option at Strike Price of INR 45, both with

a premium of INR 1 each (Graph as shown by dotted lines). Theoretically, profit will start

in the call option the moment price goes above Rs 45. However, when we consider that

besides strike price of Rs 45, we have also paid a premium of Re 1, our net cost of option

becomes Rs 46 and therefore, the profit will actually start only after market price exceeds

Rs 46. Similarly, in the put the option, theoretically profit will start the moment price falls

below Rs 47. However, in order to recover the premium that we paid, price should fall to

minimum Rs 46. Thus, when we account for premiums also, the lines shift and new graph

will look like as shown by firm lines. Now we see that at any exchange rate, the person

does not suffer any loss. In the worst case scenario, at the spot rate of INR 46, he would

break even. In any other situation, he would make some profit. There could be some loss at

times in case the premium is too high and spread between the call and put rate being

relatively small (situation represented in graph with light blue lines. Loss is shown in such case as orange

shaded area which is comparatively small).

Exotic Options

What have been discussed so far were Vanilla Options Contracts as practiced in India.

These were the contracts where there were no conditions attached to the contracts. In many

countries, options contracts are available with additional conditions. Such contracts are

called Exotic Options Contracts. While these options contracts are not available in India

through official channels, there is no bar in entering into them on OTC (Over the counter)

basis.

1. Tunnel Option Contract - This contract is also called Cylinder Options Contract. In

this case, the upper limits of exercise price for Call Option is specified. Even if the

spot price of asset exceeds the limit price, deal would be done at limit price only.

Put Option

profit Line

Call Option

profit Line

Put Option Net

Profit line Call Option Net

Profit line

Long Strangle Graph

46

45 47

Pro

fit

Loss

Premium




Thus, max loss to the Call Seller has been limited. Similarly, limit price for exercise

of Put option is also specified, thus limiting the max loss of the Put option writer.

Since the loss of writer has been capped, and the possible gain of the buyer has

been capped, the premium is very low.

Eg. Put Option sold at Strike Price of INR 46.25 with the exercise price

capped at INR 46. Now, even if the spot rate falls to INR 44, the exercise price will

be considered to be INR 46 only and the seller will pay only INR 0.25 per dollar to

the buyer.

2. Knock Out Options – This is a further amendment to the Tunnel Option. In this

case, if the spot price moves beyond the limit price, the contract is knocked out

which means that contract becomes null and void and no settlement takes place.

Such kind of contract is not possible under American Contracts method. This

happens only in European contracts where the contract expiry date is fixed. The

premium for such contract is even lower than tunnel option because seller’s

position is well protected.

3. Look Back Option – This is one option which has very high premium because it is

heavily loaded in favour of buyer. Under this option, the settlement is done at most

favourable price for the buyer in the period preceding the settlement date. It allows

the buyer to look back and select the most favourable rate in the past for settlement.

So, if the rates in the past were 46.11, 46.31, 46.55, 46,72, 46.95, 46.45, 46.39,

46.20 on the days from contract to the settlement date, Call option buyer can look

back into the past and select 46.95, which is the highest in the period, as the

settlement/exercise price. At the same time a put option buyer will be allowed to

select 46.11 as the exercise price because that is most favourable to him.

4. Average Rate Option Contract – This is also called Asian Contract. Under this

contract, the exercise price is the average of closing prices since contract date.




SWAPS

Unlike Futures and Options, Swap is not a risk management strategy. It is a strategy to take

advantage of differential opportunities for different people.

Swap, as the name suggests, is the exchange of liabilities. Two people having liabilities of

different types exchange their liabilities for some perceived advantage. For example, a

French company wanting dollar loan might be getting better rates in French Francs.

Another company in US might want French Francs but it is advantageous for it to borrow

dollars. The two can borrow what is advantageous to them and then mutually exchange

their currencies along with their payment liabilities without involving their lenders.

It could also be a swap between current and future liabilities of same person. A person may

purchase spot currency X by selling currency Y and simultaneously selling forward

currency X buying back currency Y. Thus, there is one spot deal and one forward deal.

Suppose, you are due to receive USD 1000 three months from now and have some

excellent investment opportunity in USD. So, you spot buy the USD 1000 against INR and

forward sell (three months) USD 1000. Once you receive USD 1000 three months later,

you square up the forward position and get back the rupees that you had invested.

Swap comes in many forms, like interest rate swaps, currency swaps, positions swap, etc.

(a) Spot Forward Swap – As explained above.

(b) Forward Forward Swap – Both transactions are in future but executable on

different dates.

(c) Interest Swap

(d) Currency Swap

Interest Swaps

(a) Fixed to Fixed Interest rate Swaps (Generally involves two countries)

(b) Fixed to Floating Interest rate Swaps (Mostly in same country but can be in

different countries also)

(c) Floating to Floating Interest Rate Swaps (Again, often involves two

different countries).

Example –

Company A is offered fixed rate loan in the market @ 11%; floating rate loan @ LIBOR +

0.5%. Company A prefers to take fixed rate loan. Company B enjoys better credit ratings

and therefore has been offered loan @ 9.50 % fixed and LIBOR floating. Company B

prefers floating rate. Find the Swap possibility.




Solution –

Fixed Rate Floating Rate

Company A 11% LIBOR + 0.50%

Company B 9.50% LIBOR

Difference 1.50 0.50

It is clear from above data that company B has lower rate in both the cases. However,

company B enjoys more benefit compared to A in case of fixed rate where the differential

is 1.50% as against floating rate where differential is barely 0.5%. However, company B

wants floating rate where its relative advantage is less.

In order to derive full advantage of this situation, Company B should take Fixed rate loan

even though it wants a floating rate loan and consequently, Company A should take

Floating Rate loan even though it wants fixed rate loan. After taking the loans they can

mutually swap their liabilities. If both of them had gone independently, they would have

taken loans at 11% fixed and Libor (total interest liability = 11%+Libor). But now they

have taken at 9.5% and Libor + 0.5% (Total interest liability = 9.5% + Libor + 0.5% = 10%

+ Libor) Thus, they have together saved 1% on interest cost. Now let us draw the table and

see how both companies can benefit from such a transaction.

Co Pay to

Market

Receive fm

other co

Differential Pay to

other co

Net Rate

of Interest

Old

Rate

Gain

A Libor+0.50 Libor 0.5% loss 10% 10.5% 11% 0.5%

B 9.5% 10% 0.5% gain Libor Libor-.5% Libor 0.5%

To understand this problem, look at it from another angle. Let us take company A and

forget about company B for the time being. Company A has taken loan from the market

and lent to Company B. So, it will earn interest from company B but has to pay interest to

the market. There will be some differential between the two interest rates which will be

gain or loss (gain at this stage is not mandatory). Now company A has also taken a second loan

from company B and has to pay interest for it. This interest plus the differential is the net

interest cost to the company A. Compare it with what company A would have paid had it

taken the desired loan directly from the market and you know the gain. Repeat same

exercise for company B. What is very important to note here is that while gains to both the

companies may not be equal, neither company should be in loss, else, it will not enter into

this swap transaction.

International Financial Institutions (Banks) are ever eager to swap their loans. These banks

have their assets at Floating rate where as liabilities are at fixed rate. To cover this

mismatch between assets and liability, they use swap.

Similarly, long gestation period projects like infrastructure projects prefer fixed rate

whereas banks are often reluctant to give fixed rate loans due to long maturity period.




Currency Swaps

Cross Currency Swaps Along With Swap of Interest Rate Liability.

First ever such deal was between IBM and the World Bank. IBM had CHF loan and wanted

to convert into USD loan. On the other hand World Bank wanted CHF loan but interest

rates in Switzerland had already risen quite a bit. The two agreed to swap the loan and

World Bank floated USD bonds in US market for equivalent amount to CHF loan of IBM.

Once the money was collected, they swapped their loans. IBM began to service US lenders

on behalf of World Bank while World Bank began to service IBM lenders in Switzerland.

Now suppose, World Bank issued bonds @ 3% in US market for USD 100,000,000 and

IBM loan was CHF 300,000,000 with exchange rate being CHF 3 per USD.

Company Pay to Market Other Party

pays to Co

Pay to other

Party

Net Rate of

Interest

Gain

World Bank 3% 3.10% 8.10 8%

IBM 8% 8.10% 3.10 3%

Biggest Challenge in case of swap transaction is to find another party which has

corresponding requirements where amount, duration, and type match. To fill this gap,

banks act as a mediator/broker. They charge a small fees in form of percentage of interest

gained from both the parties.

Even with banks acting as mediator, it is not always possible to find a company with

corresponding requirements. So, a trend is emerging where in the banks have started acting

as the counter party. (Is it not the same as basic function of banks? In case of direct lending and deposits,

they do not match the tenure and amount. Same is the condition in this case).

A normal deposit and lending function carries two risks:

(a) Credit Risk – The borrower may default in payment.

(b) Interest Rate Risk – In case of interest rates movement, the customer at

disadvantage may foreclose his account but the one who gains will not. The

loss will then have to be borne by the bank.

In case of swap functions, there could be another risk, ie.

(c) Exchange Rate Risk – The two currencies may move in a divergent fashion

leading to same situation as in case of interest rates.

Thus, it is necessary to cover their positions with counter swap.




Problem –

Company Fixed Floating Preference

A 10 % Libor + 0.5% Fixed

B 9.5% Libor + 0.25% Floating

Differential 0.5% 0.25 % 0.25 % (net)

Company Pay to

Market

Receive

from other

Co

Differential

(Interest

loss/gain)

Pay to

Other

Co

Net Rate of

Interest

Gain

A Libor +

0.5%

Libor +

0.375%

0.125% loss 9.75% 9.875% 0.125%

B 9.5% 9.75% 0.25% gain Libor +

0.375%

Libor +

0.125%

0.125%

Valuation of Swap

Valuation of swap is done by finding out present value of future earnings. Valuation of

Fixed rate swap is easy since earnings every year are known. In case of Floating rate

swaps, the interest is reset every six months. Thus, calculating long term valuation beyond

one or two periods is not possible.

PV of earning of Rs 100/year over 5 years = 5432 )10.1(

100

)10.1(

100

)10.1(

100

)10.1(

100

)10.1(

100

MINI CASE: THE CENTRALIA CORPORATION’S CURRENCY SWAP

The Centralia Corporation is a U.S. manufacturer of small kitchen electrical appliances. It

has decided to construct a wholly owned manufacturing facility in Zaragoza, Spain, to

manufacture microwave ovens for sale to the European Union market. The plant is

expected to cost € 4,920,000 and to take about one year to complete. The plant is to be

financed over its economic life of eight years. The borrowing capacity created by this

capital expenditure is $1,700,000; the remainder of the plant will be equity financed.

Centralia is not well known in the Spanish or international bond market; consequently, it

would have to pay 9 percent per annum to borrow euros, whereas the normal borrowing

rate in the euro zone for well-known firms of equivalent risk is 7 percent. Centralia could

borrow dollars in the United States at a rate of 8 percent.

Study Questions:

1. Suppose a Spanish MNC has a mirror-image situation and needs $1,700,000 to

finance a capital expenditure of one of its U.S. subsidiaries. It finds that it must pay

a 9 percent fixed rate in the United States for dollars, whereas it can borrow euros at

7 percent. The exchange rate has been forecast to be $0.90/€1.00 in one year. Set up

a currency swap that will benefit each counterparty.




2. Suppose that one year after the inception of the currency swap between Centralia

and the Spanish MNC, the U.S. dollar fixed rate falls from 8 to 6 percent and the

euro zone fixed rate for euros has fallen from 7 to 5.5 percent. In both dollars and

euros, determine the market value of the swap if the exchange rate is $0.9043/€1.00.

Company Pay to

Market

Receive

fm other

Co

Differential Pay to

other Co

Net Rate of

Interest

Gain

Centralia 8% 8.5% 0.5 % gain 8 % 7.5 % 1.5 %

Spanish

MNC

7% 8 % 1.0 % gain 8.5 % 7.5 % 1.5 %

Solution

Since both the companies have relative advantage in borrowing from their respective

countries, Centralia will borrow from USA $1,700,000 @ 8% and Spanish MNC will

borrow € 18,888,889 @ 7% from Spain. It is assumed that the two companies will go for

plain currency swap without any bargaining on interest rate. Thus, Centralia will take over

loan of € 18,888,889 ($1700000/0.9) and hand over $ 1,700,000 loan to Spanish MNC

along with liability for payment of interest and principal.

Payments that needs to be paid/received by each party: -

(Centralia will receive payment @ 8% per annum (ie USD 1,36,000) from Spanish MNC for 7 years and then

a lump sum payment of USD 1,700,000 at the end of 7 years. Spanish MNC will receive payment @ 7 %

annum (ie Euro 1,32,222) from Centralia over the same period and then Euro 1888889 at the end of the 7

years).

Loan Y 1 Y 2 Y 3 Y 4 Y 5 Y 6 Y 7 Y 8 Y 8 Centralia 1700000 136000 136000 136000 136000 136000 136000 136000 1700000

Spain

MNC 1888889 132222 132222 132222 132222 132222 132222 132222 1888889

Calculating Present Value of above payments:

(Please note that above are ANNUITIES (where a fixed amount is paid every year for a number of years) of 7

year each at different rates of interests. There are three methods to calculate the Present Value of an annuity

and can be calculated by any of the three methods. First method is explained on previous page).

Second Method : PV of an annuity =

nrrr

C1

11

Third Method: - Tables are available at the end of every FM book which give value of

annuity factor for any given combination of interest rate and duration. The annuity factor

can be used to multiply with principal amount to arrive at the present value of any annuity.

(The problem with first method is that it is too long and cumbersome, where as third method requires




availability of tables. It also does not give value for fraction of interest rates like 5.5. Thus, second method is

by far the best method).

So, PV of Centralia Income = 136000

706.0106.0

1

06.0

1

= 136000 x 5.582 (You will find same value against column 6% and

line 7 years in FM tables)

= $ 759,152

Present Value of lump sum payment of USD 1,700,000 =

7

06.01

1700000

=

5036.1

1700000 = $ 1,130,597

Total Present Value of Centralia Loan = 759,152 +1,130,597 = $1,889,749

PV of Spanish MNC Income = 132222

7055.01055.0

1

055.0

1

= 132222 x 5.683 (You can take average value of 5 and 6% from the

table)

= € 751,413

Similarly, Present Value of lump sum payment of Euro 1,888,889 =

7

055.01

1888889

=

4547.1

188889 = € 1,298,492

Total Present Value of Spanish MNC Loan = 751,413 + 1,298,492 = € 2,049,905

Converting the Euro into dollar amount € 2,049,905 x 0.9043 = $1,853,729

Net Loss to Spanish MNC = 1,889,749 - 1,853,729 = $ 36020

Forward Rate Agreement (Possibly a short note)

A Forward Rate Agreement (FRA) is a forward contract where the parties agree that a

certain interest rate will apply to a certain notional loan or deposit during a specified future

period of time. A FRA is similar to a Forex forward contract where the exchange rate for a

future date is set in advance. It is purely notional as the parties do not actually pay or

receive the principal sum but only settle the differential amount arising out of difference




between agreed rate of interest and the market rate of interest. Thus, suppose, a company

negotiates with a bank on 14 Sep 2006 a loan of USD 500 million for 5 years @ 6%

interest starting on 01 Jan 2007. If the interest rate in the market at the start of the loan

period, ie on 01 Jan 2007, increases to 7 %, bank will pay the company interest @ 1% for

5 year period on USD 500 million. However, if the interest rate falls to 5%, company will

be obliged to pay to the bank same amount. There is no option to back out of contract.

Interest Rate Options – In case of interest rate options, often there is a floor and a cap. In

case of wild movement of interest rates, these floor and cap come into play. They restrict

the upside and the down side for both the parties. The settlement is done within the band of

floor and cap even if the interest rates move beyond these limits.

For quite a few years Japan had a ‘0’ interest rate regime. The interest rates have begun to

harden a bit now. However, they are still abysmally low. Libor for Yen is currently at 0.15

– 0.18%. Yen loans are available at Libor plus 4 to 5 % where as Rupee loans cost as

much as 8 to 10%. Thus, there is still margin of 3 to 5 % available for an Indian Company.

When an Indian company or bank takes a Yen loan, it is hoping that the Yen won’t

appreciate compared to Indian currency, nor will the interest rate in Japan fluctuate wildly

during the loan period. But, lenders’ expectations are just the opposite. They are hoping

that Yen will appreciate and even the interest rates in Japan will harden. The deal takes

place because of contrary expectations of two parties.

Similarly, Swiss Frank Libor rate is currently at 2%. Add a few percent margin and it is

still cheaper to borrow ; but with the risk of Libor increasing as also appreciation in value

of Swiss Frank which may wipe out all the gains of lower interest rate prevailing now.

While there is a cap placed on ECB, there is no cap on Swap deals.




Balance of Payment Concept/Accounting

Balance of Payment Account is accounting record of economic transactions of the country

with the world. Any transaction which can be converted into money terms is recorded.

Balance of Payment account has three main heads: -

(a) Current Account (Revenue Transactions)

(b) Capital Account

(c) Reserve Account (Liability of Central Bank)

The rules for accounting are –

(a) Cr all transactions which lead to receipt of Forex from rest of the world but

Dr the receipt of forex itself.

(b) Dr all transactions which lead to payment of forex to Rest of World (RoW).

Cr the payment of forex itself.

This account also follows the typical double entry book keeping system. There is a

debit entry for every credit entry and vice versa. (It is the same principle which we studied

in Financial Accounting. Credit the account which generates the income (so Cr sales account for

sales) but debit the account which receives the payment or goods (so Dr cash account).

Reserve Bank Bulletin for Balance of Payment status (Sep 2006) is available at

http://rbidocs.rbi.org.in/rdocs/Bulletin/PDFs/72537.pdf (internet) or Balance of

Payment.pdf file separately.

Clarifications regarding some terminology:

Merchandise – Physical goods which can be seen and felt.

Invisibles – Which have no physical existence, like services, software, BPO, etc.

Travel – Money spent by tourists in India or by Indians tourists else where. Includes

inland travelling ticket expenses.

Transport – Fares paid for international movement of men and material. Ticket

fares paid for international travel are accounted under this head but not the

travel fares within the country.

G.n.i.e. – Government Not Included Elsewhere

Some Typical Transactions:

1. An Indian Company exporting goods worth Rs 100 million to rest of the world and

receiving payment in bank.

By Merchandise Cr 100 million

To Banking Dr 100 million

http://rbidocs.rbi.org.in/rdocs/Bulletin/PDFs/72537.pdf

Balance%20of%20Payment.pdf

Balance%20of%20Payment.pdf




2. Indian Co. exporting to RoW USD 500 million worth of goods of which it receives

50% payment immediately and rest in instalment over next 3 years

By Merchandise Cr 500 million


To Commercial Loan Dr 250 million

Suppose after one year USD 50 million is received.

By Commercial Loan Cr 50 million


3. Indian Govt receives a grant of goods worth USD 500 million after Gujarat Earth

Quake from Govt of US

By Transfer Payment Ac (official) Cr 500 million

To Merchandise Ac Dr 500 million (for accounting purpose, cases of goods grant are treated as import)

4. BHEL floats out ECB deal to RoW worth 500 million and uses the money for

buying plant and machinery for use:

By Commercial Borrowing Cr 500 million

To Merchandise Dr 500 million

5. Infosys receiving part of profit USD 500 million which is outcome of investment in

software entities in Singapore, USA and UK

By Foreign Investment A/c Cr 500 million

To Banking A/c Dr 500 million




CAPITAL ACCOUNT CONVERTIBILITY The govt has allowed De-Jure Current Account Convertibility but not De-Facto

convertibility. What it means is that current account convertibility is only in the name.

While there are no limits placed on current account convertibility for import and export

purposes, there are logical limits imposed on convertibility for other reasons like personal

travel, business travel, medical treatment, Studies, Maintenance, etc.

Convertibility on Capital Account, also called full float of rupee, is still far way off.

Even though Tarapore Committee (Salient Recommendations listed below) had recommended

Capital Account Convertibility, Govt and RBI are treading a cautious approach. The

repercussions of Capital Account Convertibility can be disastrous if things go wrong. The

world learnt it through East Asian Economic Crisis in 1997. Booming Economies suddenly

collapsed in a matter of days.

Once Capital Account convertibility is allowed, every one is allowed a free hand to

invest in and dis-invest from the country as much as and whenever he wants. At the first

sign of trouble, investors rush to dis-invest and the cascading effect on economy is

crippling. Currently, there are caps on how much Indians can invest abroad or how much

can a foreign company invest in which company/sector. In addition, before investing,

companies have to register themselves. There are caps on ECB as well.

For further details on Capital account, read last semester notes on FEMA compiled

and forwarded by Mr Parab.

RECOMMENDATIONS OF TARAPORE COMMITTEE ON

CAPITAL ACCOUNT CONVERTIBILITY

A committee on Capital Account Convertibility, was setup by the Reserve Bank of India

(RBI) under the chairmanship of former RBI deputy governor S.S. Tarapore in ----- to "lay

the road map" for capital account convertibility. The committee submitted its report in

1997. At the moment it is still a report and central bank has to accept the recommendations

of the committee.

The five-member committee had recommended a three-year time frame for complete

convertibility by 1999-2000. The highlights of the report including the preconditions to be

achieved for the full float of money are as follows:-

Pre-Conditions

1. Gross fiscal deficit to GDP ratio has to come down from a budgeted 4.5 per cent in

1997-98 to 3.5% in 1999-2000. (Yet to be achieved).




2. A consolidated sinking fund has to be set up to meet government's debt repayment

needs; to be financed by increase in RBI's profit transfer to the govt. and

disinvestment proceeds.

3. Inflation rate should remain between an average 3-5 per cent for the 3-year period

1997-2000. (had come down but inched up again over last two years).

4. Gross NPAs of the public sector banking system needs to be brought down from the

present 13.7% to 5% by 2000. At the same time, average effective CRR needs to be

brought down from the current 9.3% to 3%. (We are almost there).

5. RBI should have a Monitoring Exchange Rate Band of plus minus 5% around a

neutral Real Effective Exchange Rate. RBI should be transparent about the changes

in REER

6. External sector policies should be designed to increase current receipts to GDP ratio

and bring down the debt servicing ratio from 25% to 20%

7. Four indicators should be used for evaluating adequacy of foreign exchange

reserves to safeguard against any contingency. Plus, a minimum net foreign asset to

currency ratio of 40 per cent should be prescribed by law in the RBI Act.

8. Phased Liberalisation of Capital Controls - The Committee's recommendations for

a phased liberalisation of controls on capital outflows over the three year period

which have been set out in detail in a tabular form in Chapter 4 of the Report, inter

alia, include:-

(a) Indian Joint Venture/Wholly Owned Subsidiaries (JVs/WOSs) should be

allowed to invest up to US $ 50 million in ventures abroad at the level of the

Authorised Dealers (ADs) in phase 1 with transparent and comprehensive

guidelines set out by the RBI. The existing requirement of repatriation of the

amount of investment by way of dividend etc., within a period of 5 years

may be removed. Furthermore, JVs/WOSs could be allowed to be set up by

any party and not be restricted to only exporters/exchange earners.

(b) Exporters/exchange earners may be allowed 100 per cent retention of

earnings in Exchange Earners Foreign Currency (EEFC) accounts with

complete flexibility in operation of these accounts including cheque writing

facility in Phase I.

(c) Individual residents may be allowed to invest in assets in financial market

abroad up to $ 25,000 in Phase I with progressive increase to US $ 50,000 in

Phase II and US$ 100,000 in Phase III. Similar limits may be allowed for

non-residents out of their non-repatriable assets in India. (Phase I limits

allowed)

(d) SEBI registered Indian investors may be allowed to set funds for

investments abroad subject to overall limits of $ 500 million in Phase I, $ 1




billion in Phase II and $ 2 billion in Phase III.

(e) Banks may be allowed much more liberal limits in regard to borrowings

from abroad and deployment of funds outside India. Borrowings (short and

long term) may be subject to an overall limit of 50 per cent of unimpaired

Tier 1 capital in Phase 1, 75 per cent in Phase II and 100 per cent in Phase

III with a sub-limit for short term borrowing. in case of deployment of funds

abroad, the requirement of section 25 of Banking Regulation Act and the

prudential norms for open position and gap limits would apply.

(f) Foreign direct and portfolio investment and disinvestment should be

governed by comprehensive and transparent guidelines, and prior RBI

approval at various stages may be dispensed with subject to reporting by

ADs. All non-residents may be treated on par purposes of such investments.

(g) In order to develop and enable the integration of forex, money and securities

market, all participants on the spot market should be permitted to operate in

the forward markets; FIIs, non-residents and non-resident banks may be

allowed forward cover to the extent of their assets in India; all India

Financial Institutions (FIs) fulfilling requisite criteria should be allowed to

become full-fledged ADs; currency futures may be introduced with screen

based trading and efficient settlement system; participation in money

markets may be widened, market segmentation removed and interest rates

deregulated; the RBI should withdraw from the primary market in

Government securities; the role of primary and satellite dealers should be

increased; fiscal incentives should be provided for individuals investing in

Government securities; the Government should set up its own office of

public debt.

(h) There is a strong case for liberalising the overall policy regime on gold;

Banks and FIs fulfilling well defined criteria may be allowed to participate

in gold markets in India and abroad and deal in gold products.




INTERNATIONAL FINANCIAL MARKETS

International Financial Market can be divided as follows:

(a) Euro Currency Market

(b) International forex and bond market

(c) International equity market

Euro Currency Markets

What is Euro Currency?

Euro currency is not to be confused with currency of European Union. It has no relation to

Euro or for that matter with any currency in particular.

Eurocurrency is the term used to describe deposits residing in banks that are located

outside the borders/legal jurisdiction of the country of currency the deposits are

denominated in. For example, a deposit denominated in US dollars residing in a Japanese

bank is a Eurocurrency deposit, or more specifically a Eurodollar deposit.

As the example identifies, it is important to note that despite its name, Eurocurrencies are

not limited to Europe and as such it must not be confused with the Euro. The use of this

idiosyncratic term arose from the fact that Eurocurrency markets first developed in Europe

during the 1950s when the former Soviet Union asked London banks to hold US dollar

denominated deposits in the fear that deposits in US banks would be frozen or even seized

in the event of escalation of tension between USA and USSR.

Today, the Eurocurrency markets are active for the reason that they avoid domestic interest

rate regulations, reserve requirements and other barriers to the free flow of capital.

Thus, Euro currency is not any currency in particular. A Eurocurrency is any currency that

is deposited in a bank outside its country of origin. So, there can be Eurosterling,

Eurodollar, Euroyen, Euromarks and so on.

Euro Currency operations are not limited to cash. They can be in any kind of financial

instrument as long as the deal is cross currency and cross national. They can be in the form

of:

(a) Euro cash deposits

(b) Euro Bonds

(c) Euro Commercial Papers




What is Euro Currency Market?

Euro currency market is the foreign currency market which specializes in the facilitation of

borrowing and deposits of currencies outside their country of origin. For example USD

deposits or USD loans made available by a bank in London.

Reasons for Rise of Euro Currency Markets

Euro currency markets emerged in the decade of 1950s and 1960s on account of

following –

1. Cold War between USA and USSR – The dollars earned by USSR through

weapons sale and other exports needed to be invested outside USSR.

2. Oil crisis which benefited gulf countries. Petro dollars earned by middle east

countries needed to be invested. America has been having a love hate relationship

with Middle East for a long time and therefore they did not want to park all their

petro dollars in USA. In addition, deposit rates on external deposits were

comparatively low in USA.

3. Relaxation of banking norms in the European region.

Main centers of Euro Currency markets are London, Frankfurt, Singapore, Hong Kong, etc.

Categorization of Euro Currency Market

1. Euro Deposit Market / Euro Credit Market – This refers to simple deposit and

lending function of a third country currency in Euro Bank.

2. Euro commercial paper market.

3. Euro Bond Market – E.g. An Indian Corporate house floating bond denominated in

terms of Yen or dollars in London.

Advantages of Euro Deposit / Credit Market

Euro Banks are normally beyond the tight controls of Central Banks of the country and do

not need to follow the stringent SLR and CRR ratios, interest rate regulations, etc. This

lowers their cost of operation and thus, they are able to offer better deposit and lending

rates than normal domestic banks.

Offshore Financial Centre

OFC are certain specific locations on the world map –

1. Which are tax heavens




2. Enjoy scenario of low or no government regulations and

3. Offer the advantage of banking secrecy and anonymity. Like erstwhile Swiss Banks

which were notorious for being repository of black money of the world, Offshore

Financial Centres provide similar secrecy and anonymity though they do not enjoy

same kind of confidence as Swiss Banks.

There are some 55-60 OFCs in the world. Some well known financial centers are –

Bahamas, British Virgin Island, Cayman Island, Hong Kong, Maldives etc.

Use of Offshore Financial Centers

1. For establishment of offshore banks.

2. For establishment of international business corporations.

3. For tax evasion and money laundering.

SEZs, which are mushrooming in India and China, are mini versions of Offshore Financial

Centres.

What is an Offshore bank?

(a) A bank which carries deposits of such depositors who are either non-

residents or are residents but maintain the foreign currency accounts.

(b) Offshore banking entities do not bank in terms of the currency of the

country where they are located but deal in forex deposits and loans only.

Thus, an Indian Offshore bank can not deal in INR. All its transaction will

be in any currency but INR.

Advantages of Offshore Banking

(a) Secrecy of accounts.

(b) Tax advantage

(c) Offshore banks do not need to follow the reserve requirement guidelines and

have lower regulatory expenses Thus, their lending rates are lower and

deposits rates more attractive.




International Bond Market

Categorization of International bond market –

(a) Euro Bonds

(b) Foreign Bonds

(c) Global Bonds

Euro Bonds

Bonds in the currency other than the currency of the country in which they are floated by a

company of the third country called Euro Bonds. Thus, if an Indian company floats USD

denominated bonds in UK, they will be called Euro Bonds.

Foreign Bonds

Bonds which are floated in the local currency of the country of floatation by a foreign

company are called Foreign Bonds. Thus, if an Indian company floats USD denominated

bonds in USA, they will be called Foreign Bonds.

Types of Foreign Bonds

(a) Yankee Bonds – These are foreign bonds floated in USA

(b) Bulldog Bonds – These are foreign bonds floated in UK

(c) Samurai and Shibosai Bonds –

(i) Samurai – These are Yen bonds floated in Japan in open market.

(ii) Shibosai – Yen bonds floated on Pvt Placement basis in Japan.

(d) Dragon Bonds – These are foreign bonds issued in local currencies of the

South Asian countries.

Other Types of Bonds

1. Straight Bonds – These are plain vanilla bonds with fixed rate of interest and fixed

date of maturity.

2. Floating Rate Bonds – These are LIBOR linked variable interest rate bonds

wherein interest rate is adjusted every 6 months.

3. Convertible Bonds – These bonds convert into equity share after the specified

period of time. In this category, there could be fully convertible or partly

convertible bonds.

4. Floating Rate Bond with Collars – These floating rate bonds have upper and

lower limits of interest rate variation. Thus, the max and min interest payable are




capped irrespective of movement of interest rate in the market.

5. Bonds with Warrants – These are the bonds which are accompanied by an option

to the buyer to buy specified number of equity shares for a specified price at some

specified time in future, often prior to expiry of the bonds. He may or may not

exercise this option depending on the market price of the share vis a vis offer price

at the time of buy. He may even sell this option to some one else at a premium.

These are not same as Convertible Bonds. There is a minor variation from

convertible bonds. In case of convertible bonds, the money which was paid as bond

price is not paid back and shares are issued in lieu. In case of warrants, additional

money is paid for exercise of option while bond money is paid back on maturity.

Warrant option is used as a sweetener to float bonds with lower interest rate.

In case the probability of share price appreciation is very high, they could be even

at Zero interest rate.

6. Zero Coupon Bonds – These are also called Deep Discount Bonds. These bonds

are issued as zero percent interest rate bonds but at a discount to the face value.

Bonds are paid back at face value on maturity. Thus, the discount on the face value

actually represents the interest component. However, this trick is played to beat the

tax system of the countries where interest income is charged to tax.

7. Callable Bonds – These are the bonds wherein the company reserves the option to

call back the bonds prior to maturity but after the lock-in period. Such bonds are

issued when

(a) It is a fixed rate bond and there is strong probability of softening of interest

rates in future.

(b) It is a floating rate bond and there is strong probability of hardening of the

interest rate in future.

8. Puttable Bonds – These are bonds wherein the buyer has option to sell back to

company any time after the lock-in period. Such bonds are issued if the company

does not enjoy very good credit rating in the market to give some confidence to the

investors.

9. Dual Currency Bonds or Hybrid Bonds – These are bonds which are sold in one

currency and payment of interest or principal or both is done in another currency.

Eg. An Indian company may float a USD bond in US and pay the interest and

principal back in INR.

Bond Issue Procedure

1. Issuing company takes the approval of the Board of Directors.

2. Issuing company appoints Lead Manager.




3. In consultation with the issue manager, the company appoints Co-Managers, Under

writers, Brokers to the issue.

4. The Lead manager prepares the draft document for the bond issue and the bond rate

is decided.

5. The draft prospectus is discussed and is given the final shape.

6. Listing formalities are completed by the company and the Issue Manager.

7. Announcement of the issue is made.

8. Investor response is monitored.

9. Final bond issue is made.

10. Tombstone advertisement is published – It is in the form of Thanks advertisement

detailing the response and money collected.

External Commercial Borrowings

There are two routes for raising ECB:

(a) Automatic Route

(i) Corporates – up to USD 20 million for 3 years and upto USD 750

million for 5 years and above.

(ii) NGOs – Allowed micro credit of upto USD 5 million.

(b) Approval Route – Even though limit are same but banks and financial

institutions have to take prior approval.

However, ECB can not be raised from just any body. Like the banks have to follow KYC

(Know your customer) norms, ECB borrowers have to follow KYL (Know your lender)

norms. The borrower needs to get a due diligence certificate from an approved overseas

bank that the lender has held a satisfactory account with it for at least 2 years.

Forms of External commercial borrowing – Following credits are deemed to be

ECB

(a) Buyers’ Credit – The advances received from a buyer are deemed ECB.

(b) Suppliers’ Credit – The credit period allowed by supplier is deemed ECB.

(c) Short Term Borrowings – Loans raised for one year or less. Commercial

papers, issue of Certificates of Deposits.

(d) Fixed rate and Floating rate bonds -.

(e) Loans from International Financial Institutions – Various international

financial institutions like Asian Development Bank, The International

Finance Corporation (IFC) and the Multilateral Investment Guarantee

Agency (MIGA) and including World Bank (But not IMF) lend for various

projects.

(f) Syndicate Loans – These are large loans for which no single bank wants to




take full exposure. Thus, a group of banks join together and lend as a group.

Thus, the risk is spread out. Loan to Enron Corporation for Dabhol Power

Project is one example of syndicated loan.

Procedure of Syndicate Loans

1. Borrower prepares Information Memorandum (IM).

2. IM carries details of the borrower, the amount of loan needed, proposed maturity

period of the loan, purpose of the loan etc.

3. Borrowers send invitations to the international banks along with the IM.

4. Borrower receives credit proposals and analyses them.

5. It enters into agreement with lead syndicate bank which deals with other banks in

the syndicate.

6. Information of the deal is submitted to the Ministry of Finance and to the Reserve

Bank of India.

Equity Market

There are two routes for raising equity capital from foreign markets:

(a) Listing company’s shares in those countries’ stock exchanges

(b) Through Depository Receipts (ADRs and GDRs)

The biggest problems faced in raising the equity money from foreign markets are the

accounting standards (US GAAP and others), disclosure norms (which are pretty tough in

advanced countries), expenses and time involved.

However, raising money through ADR and GDR is still easier than listing on the foreign

stock exchanges. Two popular terms for Depository Receipts are ADR and GDR which

stand for American Depository Receipts and Global Depository Receipts respectively.

ADRs are Depository Receipts issued in USA while GDRs are the Depository Receipts

which are issued in many countries.

Definition: An ADR is a negotiable certificate issued by a U.S. bank representing a

specified number of shares (or one share) in a foreign stock that is traded on a U.S.

exchange. ADRs are denominated in U.S. dollars, with the underlying security held

by a U.S. financial institution overseas, and help to reduce administration and duty

costs on each transaction that would otherwise be levied.

The advantage of ADR/GDRs to local investors is that they do not have to buy and sell

shares through the issuing company's home exchange, which may be difficult and

expensive. In addition, the share price and all dividends are converted into the shareholder's

home currency.




The process of ADRs and GDRs involves selling the shares (without voting rights) to a

Depository Participants (Some International Bank). This Depository then sells those shares

in its markets. Buyers of the Depository Receipts have right over the shares of the

company. There is rarely one to one relationship between DR and the Shares of the

company. It could be any ratio, say One ADR = 10 Shares.

Fungibility – Fungibility is Interchangeability. Here, it is facility to convert Depository

Receipts in to actual shares. Two way fungibility means permission to convert Depository

Receipts to shares and then back to ADRs.

date: 20 jul 2006 mrs smita shukla - wordpress.com replaced the foreign exchange regulation act of...

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